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The Canadian Moral Hazard Corporation

On January 17, 2011 Finance Minister Jim Flaherty and Natural Resource Minister Christian Paradis announced that they would be making ‘prudent adjustments’ to the rules for government-backed mortgages.[1] The press release was laden with the usual self-congratulatory fanfare and statements obviously designed to assure the reader that Canada has a ‘well-regulated housing sector’ and that the government ‘will continue to take the necessary actions to ensure stability and economic certainty in Canada’s housing market.’ Either Mr. Flaherty is unaware of the issues facing the Canadian mortgage industry, or is simply trying to create the illusion that the government is doing something about it.

The Canadian mortgage market is dominated by the Canadian Mortgage and Housing Corporation (CMHC) and this government-owned company operates in much the same way as Fannie Mae and Freddie Mac. The CMHC insures mortgages and guarantees mortgage-backed securities that trade in the secondary market. In comparison to Fannie Mae though, the prognosis of the CMHC is just as bad or worse. For instance, at the height of the housing boom in 2007 Fannie Mae had guaranteed over $2.3 trillion in mortgages[2], nearly a quarter of the mortgage market. As of 2010 the CMHC guaranteed about$514 billion in mortgages,[3] over 50% of outstanding mortgage credit.[4] Fannie Mae had approximately $44 billion in net assets to cover those guarantees, giving them a leverage ratio of about 50:1. The CMHC has about $11 billion in net assets to cover theirs, with the ratio nearly working out to 47:1. To make matters even worse, 74% of the CMHC’s assets are invested in those very same mortgage-backed securities. If the Canadian housing market ever took a dive the CMHC would be bankrupt in the blink of an eye.

The measures announced last January by the government are clearly geared towards ensuring that the CMHC doesn’t implode. To put things in perspective, the CMHC’s guarantees are nearly twice the entire national debt. It’s highly unlikely that every single mortgage would go into default, but even having to cover 10% of them would grow our national debt of $560 billion by nearly 10%.[5]

The first of the new measures reduces the maximum amortization period from 35 years to 30 on new government-backed mortgages. The government correctly says that this will reduce the total interest payments Canadian families make. However the problem isn’t with mortgages that are going to be made, but with the mortgages that have already been made and this measure does absolutely nothing to address it. While it will reduce the total amount of interest paid, monthly payments will necessarily rise. A family obtaining a $350,000, 5% mortgage will pay $113 more per month once these changes go in to effect compared to the same mortgage being amortized over 35 years.

The second measure reduces the amount Canadians can borrow out of the value of their home from 90% to 85%. I’m really curious as to how much effect Mr. Flaherty really thinks this is going to have. A 5% change is an empty gesture. After all, it only means that a person would be able to borrow $85,000 instead of $90,000 out of the value of their $100,000 home, hardly a difference that would make or break someone’s decision. Flaherty claims that this will ‘promote saving through home ownership’ but this only reveals that our government is still completely ignorant of one of the main causes of the failure of the US housing market; homeowner’s ability to use their houses as piggy banks in the first place!

Thirdly, the government is eliminating its insurance backing on lines of credit secured by homes. The fact that the government only marginally reduced the amount of credit a customer could obtain, while simultaneously completely withdrawing their guarantees on that line of credit is telling. It means that there is a fear in the government that a default is coming. The government is already guaranteeing the house, why further guarantee their home equity line of credit? They’re removing an exposure to losses that they’ve deemed too risky. There is a silver lining to this measure though. Now that the guarantee is gone, banks will be more cautious in giving out loans secured by homes in the future since they’re playing with their own money now and not the governments.

The activities of the CMHC have, much like its American cousins, been taken to reckless excess. Even a slight increase in the default rate in Canada will devour the company whole. With the increasing risk of losing the U.S.A. as our major export partner and significant source of our GDP as they further endanger their currency and economy, the likelihood of this event is looking ever more probable. The actions taken by Mr. Flaherty and Paradis show that the government is only marginally aware of these problems and clearly do not see a solution except to try and curtail further damage. Too little, too late has been the drumbeat of every government when it comes to undoing bad policy and January’s announcement only shows that Canada is no exception.

We have long heard shouts of denial from the media and other ‘experts’ that Canada is in a housing bubble, or could wind up experiencing a string of defaults like what happened in the U.S.A. beginning in late 2007. Unfortunately for these deniers facts can be stubborn things, for indeed our housing prices have been rising exponentially over the past years. A story that ran in the Financial Post last August identified a report issued by the Canadian Centre for Policy Alternatives where they argued that the residential real estate market, particularly in Toronto, Vancouver and Calgary, is “an accident waiting to happen.”[6] If the following chart is any indication, they’re not exaggerating.

Canada vs. US Real Estate

Compared to the United States we have experienced nearly an identical boom in real estate. The signs were, of course, everywhere. House-flipping shows were airing practically 24/7 on television and no money down mortgages became a common sales pitch with mortgage brokers. The availability of these loans was a direct result of the backing the CMHC was handing out like candy.

The article later notes that the strength of the mortgage market in Canada is the reason why Canadian banks have performed so well when compared to foreign banks during this crisis. Households in Canada have managed to meet their mortgage payments because employment levels have stayed relatively healthy. The reality though, is that Canadians are just as leveraged as their American counterparts.

Debt to Income Ratios of Selected Countries
Consumer Debt per Capita

The average Canadian of 2011 looks exactly the same as the average American of 2007, and the average American lost their shirt. They have borrowed out all the equity in their homes in the form of HELOC’s and other lines of credit and went on a spending spree. Likewise, our savings rate has strayed dangerously low.

US and Canadian Savings Rate

The same events happening all over the globe will happen here as well. For a number of years now Canadians have been on a debt-fuelled spending binge. The trigger could come in any number of ways. In the U.S.A. the central bank began raising rates as a wave of mortgage resets swept by. Debtors could no longer afford their new monthly payments and wound up defaulting. In Canada, our central bank has said that it would not raise rates until 2012.[7] The reasons why could not be more clear. The government is well aware of the problems inherent within the mortgage market, but like all good Keynesians think that they can delay the pain forever with low interest rates.

The only problem is that our economy is closely coupled to that of the U.S.A. About 73% of our exports or 22% of our GDP comes from doing business with our southern neighbours.[8] When they can no longer afford to buy our exports, what will happen to our export industry? More than likely there will be a series of layoffs as firms restructure themselves in an attempt to find new customers. Many others will simply go out of business. The unemployment resulting from this could easily be the pin to pop our housing bubble.

Whatever the trigger may be, our government’s reaction will likely be the same as the U.S.A. They will sweep in to support the CMHC with bailouts and guarantees. The Bank of Canada will continue to do everything they can to keep interest rates low in order to forestall the defaults. These actions will only paper over the problems that are now deeply-rooted in our financial system and further debase the currency. Furthermore, with nothing behind the Canadian dollar except for US dollars and Euros, this could happen much quicker than expected as well.[9] For the moment though, our government seems content to continue staring in to the abyss. They may feel differently when it begins to stare back.

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